From VAR to SPAR

MEK's Miral Kim-E proposes Stock Price at Risk (SPAR) to help corporate risk managers express market risk in terms of shareholder value.

Corporations have lately been investigating value-at-risk simply because "it's there." But after taking a closer look, many corporate treasurers have discovered that fitting VAR into the context of their own operations is in many ways forcing a square peg into a round hole. To a large extent this is because VAR was designed specifically with banks and their trading operations in mind.

But for corporations, the outright financial transactions are only half of the story. Most companies are hedgers, meaning that they purchase forward contracts or swaps in order to mitigate specific market risks or to reduce their overall earnings volatility. Potential variance in the value of a firm's hedges must be considered in conjunction with the variance of the underlying loans, business deals and assets that the company may be attempting to hedge.

Some firms are attempting to get around this by translating their exposures into approximately equivalent cash flows and/or simple financial instruments which can then be marked to market and analyzed along with their hedges. Extending the mark-to-market approach to "make VAR work," however, has two substantial drawbacks. First, many corporate exposures cannot be accurately described by simple cash flows. For example, a firm which routinely hedges a certain portion of its anticipated business transactions must find some financial equivalent for, say, likely future sales of widgets. And, second, VAR does not address one of most companies' most pressing concerns, which is the relationship between volatility and shareholder value.

In order to create an appropriate risk measure for corporations, I've developed a new type of risk measurement called Stock Price at Risk (SPAR), a technique designed specifically to help bridge the gap between the goals of risk managers and senior management by allowing risk managers to express any risk in terms of its potential threat to shareholder value.

Redefining risk

The first goal of SPAR is to refocus risk management strategy on shareholder value. This means that rather than defining risk as the mark-to-market volatility of tradable instruments either on or off the balance sheet, risk is defined according to accepted measures of shareholder value. While the precise definition of shareholder value will tend to vary, it is usually tied to one or more of the following: future stock price targets, future stock price targets relative to certain benchmarks, such as the S&P 500 or an industry-wide index, or future cash flow targets such as earnings-per-share (EPS) or earnings before interest, tax, depreciation and amortization (EBITDA).

Risk, then, can be expressed in terms of the probability that shareholder value goals-as described above-will not be met. One helpful by-product of this change in focus is to bring risk managers and business managers onto the same side. Rather than focusing on the quantification of risk in mark-to-market terms-and "micro-managing" individual instruments and markets-risk managers can look at volatility as just one of many factors which can impact shareholder value. In other words, rather than talking Greek (delta, gamma, etc.), risk managers can talk about reaching EPS targets.

Furthermore, this approach leverages existing corporate expertise to a much greater extent than the bank-driven VAR approach. SPAR recognizes that the asset/liability structure of corporate cash flows can lead to unconventional solutions to risk management problems, such as taking advantage of "internal hedges" in order to reduce risk management costs.

The methodology

In very general terms, SPAR considers stock price as a function of a firm's price-to-earnings ratio and its revenue and expense streams.

EPS can be determined through projections for each of these three parameters, which are readily available in nearly all corporations. Revenue projections, for example, are often available for a wide range of economic conditions. Non-market-related expenses are generally easy to project, as they are relatively stable, while market-dependent expenses, such as interest expense, commodity costs and FX translation, must be modeled as in any VAR calculation. And projections of shares outstanding also tend to be reasonably stable, although this may be more or less influenced by the market depending on the nature of any stock buy-back programs in place, employee stock options outstanding and uncalled convertible bonds.

Forecasting the P/E ratio, however, can be trickier than building an estimated EPS because the stock market's volatility is embedded in the factor. But it still is fair to say that this ratio for a given company will rise or fall relative to the market at large based on the market's perception of the predictability of that company's EPS.

By modeling both P/E ratios and EPS, it is thus possible to create a combined model that can simulate a company's stock price under various conditions. Then this model can be used with any type of scenario to demonstrate the impact of various risks-including, of course, market movements-on projected cash flows and stock price. Because companies tend to have highly individual methods of estimating their cash flows and setting targets for stock price, SPAR is intended to be a rather broad and flexible concept, capable of accommodating any firm's own internal approach.

SPAR in action

Consider the case of a company that, for cost purposes, wants to increase its portion of floating rate debt from 25 percent to 50 percent. According to SPAR, the first step for this firm would be to consider how this change in the ratio of fixed to floating debt might affect EPS and, by extension, stock price. The tradeoff which this company will be asked to consider is whether the probable cost benefit of taking on additional floating debt equals or outweighs the potential downside of an unfavorable interest rate move.

Let's assume, then, that this firm's internal analyses have concluded that future EPS targets can be achieved through greater amounts of floating debt, but the concern now is EPS volatility. Let's also say that the company's EPS for 1995 was $1.00, with projections of $1.05 for 1996 and $1.22 for 1999; volatility for short-term interest rates is 20 percent over a five-year horizon; and the P/E ratio is 15.

First, let's analyze how changes in the predictability of projected expenses due to the new debt scenario will, in turn, affect the future volatility of EPS.

Clearly, increasing the amount of floating debt relative to fixed will result in greater EPS volatility-and, by extension, stock price volatility. But how does it compare with the reduction in interest expenses that managers also predict? Let's say the portfolio of debt is approximately $400 million; an average yearly cost saving of 100 basis points is projected. If the initial mix of debt is $300 million at 7 percent fixed and $100 million at an average floating rate of 6 percent, and this mix is modified to $200 million fixed and $200 million floating, an interest cost of $1 million will be saved in one year. For 100 million shares outstanding, this will result in a saving of one cent per share per year. However, when the effect of investing the $1 million into improving business operations is considered, that initial savings is more like two cents per share.

And let's also consider return on equity. Given a 20 percent return, that estimated annual two cents per share will in reality be even greater; the first year's saving will actually be about 2.4 cents (that is, 2 cents + (0.2x2 cents)), the second year's saving about 2.88 cents, etc.

Of course, targeted scenario analysis should be used in order to calculate the likely damage should any of the assumptions made above turn out to be substantially wrong.

So what can this company do in order to reap the substantial cost benefits of changing its mixture of debt while mitigating the above-mentioned volatility effects? To provide managers with enough information to select the optimal strategy, SPAR analysis would consider the following:

• Are there interest-rate-sensitive cash flows on the revenue side that might decrease or increase the risks?
• If interest rates spike upward, by how much could the EPS target be missed before the market senses that the P/E multiple and the outlook for future earnings will drop, thereby reducing the chance that this company will meet its stock price targets?
• What can be done to ensure protection against interest rate spikes?
• How might various hedging and revenue-boosting strategies perform?
• Would the cost of the insurance outweigh the benefit?

Using the data

One of the most important aspects of SPAR is that it points toward a number of specific cost-saving hedging strategies. For example, since stocks still trade based on EPS, which is by nature the average result of activity over a quarter or year, it may not be necessary to hedge ongoing exposures, such as foreign revenue, commodity purchases and short-term interest rate expenses, point by point. Instead, in many cases companies can hedge their average exposures at a lower cost while still effectively protecting their share price from volatility.

For instance, a company might do well to purchase a cap on the average value of LIBOR over a particular period rather than buying a plain vanilla cap on LIBOR for the same period. It is the average value of LIBOR that will eventually show up on the expense line, and a cap on average LIBOR will be less expensive than a cap on plain LIBOR.

Future implications

One of the ongoing themes in corporate risk management is how can treasurers and others involved in making risk management decisions explain their rationale-and the impact of the market transactions they enter into-to top business-side executives and boards of directors. With SPAR, not only will business managers be able to understand the "risks" identified by their treasury brethren, but they will also be able to actively participate in risk management decision making, helping to develop a genuine, firmwide risk management mandate that can only benefit shareholders and employees alike.